Friday, July 31, 2015

I have sometimes used 30 year mortgage rates as a proxy for expected returns on homes. I have previously justified this from a bottom-up, required rate of return, point of view. They are both securities with very long durations and exposure to the same type of asset. But, I wonder if a market arbitrage justification is stronger. If expected returns from home ownership are higher than mortgage rates, then home buyers would leverage up on mortgage debt and bid the price of houses up until those rates of return equalize, and vice versa. In fact, everyone basically agrees that this is what happened in the 2000s. Most people seem to think that it is because (1) home buyers had false hopes for expected returns in their homes and (2) mortgage rates were held low by the Fed. I don't disagree with this, except that (1) those hopes have been justified by continued supply constrictions and rent inflations and (2) long term real rates were low, in part, because of tight monetary policy, not loose policy.

I think the data bears this out - housing keeps pretty efficiently to no arbitrage pricing. But, before I get to the data, I just want to note that this shouldn't be controversial. Even though it is usually put in terms of homebuyer demand ("We get a housing bubble when mortgage rates are low and homebuyers expect prices to go up."), this is basically saying the same thing ("Expected home returns will converge with mortgage rates.")

I like to start with the BEA and Fed Flow of Funds data. From the Fed, we can get the market value of owner-occupied housing and outstanding mortgages. From the BEA (table 7.12) we get owner-occupier housing expenditures, including an estimate of depreciation. One of those expenses is net interest, which, divided by outstanding mortgages gives us an aggregate estimate of mortgage interest rates. The BEA also gives us net rental income after all expenses and depreciation. Rental income plus net interest expense, divided by total home market values, gives us the aggregate total return to home ownership.

Here is a graph of those measures. Mortgages are a nominal security, but housing returns are real. In other words, future mortgage payments are fixed, but net rent to the homeowner will rise with inflation. So, expected inflation is embedded in the mortgage interest payment while the mortgage principal remains fixed, but for the homeowner, rent and the property value inflate over time. So, expected inflation is the difference between the interest rate on mortgages and the return to the homeowner.

I like using these measures, but we quickly run into problems. First, most mortgages have a fixed rate, so the interest rate here is somewhat backward looking. But, even solving this problem would not solve all of our inflation issues. There is a difference between expected inflation premiums and experienced inflation. Since a mortgage is nominal and a home is real, owning a leveraged home is taking a long position on inflation. So, during periods of unusual inflation fluctuations, the real returns on homes remain fairly level, but the gains and losses on their short mortgage position are substantial. This makes measuring the reliability of no arbitrage pricing difficult. It would be nice if I had a long historical data set of real long term bond rates.

In the Fred graph from the earlierposts on this topic, we can see a pretty reliable parallel between home yields and real 30 year treasuries from 1990 to 2006. The data above go back to 1950, but the 1970s and 1980s are a little tricky, because it is hard to separate out actual inflation, expected inflation at different durations, and inflation uncertainty.

﻿﻿﻿﻿Here is a graph that compares the 30 year mortgage rate to my measure of housing yields to arrive at an alternate measure of inflation premiums.

﻿

The blue line is the inflation premium implied by the effective
aggregate interest rate paid by homeowners.

Now, if we compare all of these measures to smoothed 5 year CPI inflation and CPI Shelter inflation, we see that the inflation premium derived from the 30 year mortgage matches actual inflation pretty well. But, during the times when inflation is stable (roughly 1955-1965 and 1990-2015), all measures move together pretty well. (I'll address 2002-2015 with more detail later.)

This may not seem like a big deal. These are, admittedly rough measures, so the error bands implied by my visualizations are pretty broad compared to the ranges of each variable. But, it is important to also consider the counterfactual. One thing I think we can say here with confidence is that the idea that home buyers are not operating within typical models of financial tradeoffs and that home prices can be pulled into the stratosphere by naïve and hopeful buyers is not remotely supported by the data.

One way to think of the inflation premium measures in these graphs is that they represent the level of inflation that completely leveraged homeowners would need to experience in order to avoid capital gains or losses on the real value of their mortgage principal. Or, put another way, if mortgage rates and home yields are, indeed, arbitraged through efficient markets, this inflation premium represents the inflation that the marginal homebuyer expects to see. So, if home prices were being bid up to unreasonable levels because of over-optimistic speculators, we would see that inflation premium rise.

Some critics of the housing boom reference survey data where homebuyers appear to have very optimistic expectations about future home values. But, what we can see here is that these expectations did not factor in the home prices. Home prices during the boom did not depend on excess rent inflation for their valuations. Implied inflation was 2% to 3% during the boom. The counterfactual that seems to be widely believed is that the inflation expectations that buyers used to justify home prices during the boom was as much as 10% or more. There is no evidence for that at all.

To look at this a little more closely, here is a graph of the difference between the spot rate of 30 year mortgages and the effective aggregate rate paid by homeowners. The effective rate tends to be more stable and the spot rate is more cyclical. In the 1970s we can see the spot rate climb as inflation spiked, while many homeowners retained their existing mortgages with lower rates. We don't tend to see this separation when rates are decreasing because owners can refinance at lower rates. In the inflation graph above, we can see that the inflation premium implied from the BEA data actually declined in the 2000s. In other words, home prices became especially conservative during that period. Home prices were justified, even if rent inflation began to subside.

Looking back at this graph of mortgage rates, the effective rate dipped during this time. So, it could be that effective rates were declining because of teaser rates, ARMs, and generally shorter durations. If we adjust for that, the effective rate might be closer to the running inflation rate, but it clearly was not above it.

On the other hand, the inflation premium implied by the spot 30 year mortgage rate did bump up during the boom. It's a little more noisy than the effective rate, but the noise does point to a higher required inflation rate during the boom. However, if we look at mortgage spreads between mortgage rates and treasuries, we see an increase in the spread. This can be easily missed, because, from a mortgage investor point of view, rate spreads with 10 year treasuries may be more common. This is because prepayments lower the effective duration of a basket of mortgages. But, from the perspective of home value arbitrage, the duration of a 30 year mortgage is more similar to a 20 year treasury bond. What we see is that the spread between mortgages and 10 year treasuries was fairly stable in the 2000s, but after 2003, the spread between mortgage rates and 20 year treasuries jumped by more than a half point.

So, the higher required inflation implied by 30 year mortgage spot rates signals conservative bankers as much as it signals optimistic home buyers. The trend toward shorter duration and floating rate mortgages after 2003, as with so many pieces of evidence here, can fit in both a "bubble" story and a reasonable efficiency/arbitrage story.

In either case, homebuyer expectations were within the range of trend inflation.

This inflation premium gives us another way to look at the notion that if we didn't have artificial barriers to homebuilding, shelter inflation would converge with core or broad consumer inflation over time. This is because mortgage investors would arbitrage mortgage rates with other bonds. Rent inflation would have little relevance to them, in terms of interest rates. Compared to the rate on real bonds, mortgage investors would require an inflation premium reflecting broader incomes and consumption.

But for homebuyers, the inflation premium that would be important would be rent inflation. It would be changing rent inflation that would change the income of their investment from their original expectations.

In an unencumbered market, if shelter inflation and broad inflation deviated, home supply would expand until they converged. If shelter inflation was high, home buyers would be enticed to buy homes on leverage, funding new building, which would pull down rents until the inflation rates converged. In addition to an arbitrage between nominal and real returns on investments, there would be a natural arbitrage between rent inflation and broader inflation.

But, since large segments of the real estate market in many large cities are incapable of market-based supply responses, this arbitrage has been playing out through price much more than through quantity. The rising prices are a measure of this inefficiency. If housing supply markets were efficient, it would take very small price adjustments to create supply reactions. The end result of rising rents would be new building that led to subsequently falling rents. But, since some large markets have housing supply that is very inelastic, home prices must rise until real yields on homes fall enough to bridge the gap between the two inflation premiums. This also means that when there are sharp supply constraints, in a market with efficient demand homebuyers will rationally be led to take on higher leverage, because the supply constraint will provide persistent arbitrage profits. Could the rise in mortgage spreads after 2003 reflect caution from the banks? Perceived risk resulting from the moderation of rent inflation that happened briefly while home building was at its peak, which led mortgage rates to rise, so that banks were claiming some of the profits available from the inflation arbitrage?

A point of distinction to think about here is the difference between rent inflation and home price inflation. The surveys of the optimistic homebuyers tend to relate to home prices. Housing rents tend to be much more stable. But home prices are based on a complex, very long duration security. In a housing market that has reasonable valuations, as we see in the measures above, homeowners could reasonably expect double digit price increases for several years if local rent inflation is not expected to abate. This sort of price behavior is not unprecedented, and we should expect it to be especially possible in today's environment where metro area supply constraints are especially bad, and naturally low real interest rates make intrinsic values especially volatile.

Real yields on homes were just over 2% at the top of the boom, and were in line with long term real treasuries. Rent inflation had been running at about 3% compared to broad inflation at closer to 2%. Home values become undefinable - infinite - if those inflation levels sustainably diverge by 2 1/2%, matching the real yield. Now, there may be reasons why that wouldn't happen, but there is a lot of space between a few years of 10% price gains and infinity.

As for the period since 2007, arbitrage has failed. Homeowners now don't require any rent inflation to justify home prices. Any rent inflation is an excess gain for them. And rent inflation is now running at 3%.

Thursday, July 30, 2015

Before I go into the next post about long term no-arbitrage pricing for homes, I want to address the notion of a home as a security.

First, I realize that as individual assets, homes have an extremely localized exposure. Because of the way we own homes, we regard them in this framework, and that works for the purposes of individual wealth management decisions. But, this is really no different than corporate equity. Firms also can have high idiosyncratic behaviors. And, in fact, just as households and home ownership decisions, most work done by financial analysts is concerned with these idiosyncrasies. So, the localized nature of homes does not particularly set them apart from other asset classes.

There is something interesting to think about here, regarding modern portfolio theory and the effects of diversification. Theoretically, the ability to diversify away idiosyncratic risk creates a marketplace of securities with returns that, in the aggregate, reflect only the systemic risks of the asset class itself. We tend to think about the ability to actually hold a good facsimile of the market basket of securities as the process through which this takes place. But, an individual investor can accomplish most of the available risk reduction of diversification with only a handful of securities. And, in the end, the arbitrage of prices to reflect systemic and idiosyncratic risks really comes from a more diffuse and complex set of trades and allocation decisions that don't necessarily rely on any single investor to be fully diversified.

In fact, it appears to me that this process can take place with a seemingly thin network of potential trades. It is hard for us to conceive of the millions of allocation decisions and how each decision creates a network of 1st and 2nd order effects on its potential substitutes.

Thinking about these things in housing is always complicated by the coincidental nature of housing consumption and home ownership when most households supply their own demand. It is important to keep these actions separate for useful analysis, and I find that they almost never are. So, we might think of decisions about moving between cities, population flows, etc. as part of this process, but those changes are changes in housing consumption. They are priors in the market for home ownership. Markets for home ownership are pretty efficient, so, given these priors, just a small set of transactions on the margin pushes prices to account for fundamentals. More often than not, these marginal transactions probably involve landlords who must treat the transaction mathematically.

So, what I find is that returns to home ownership are actually bid down to a return level that reflects few returns, on net, to idiosyncratic risk and reasonable returns on risk adjusted investment. Homes, in the aggregate, have very stable incomes - similar to the income on inflation-protected bonds - and rather than having default risk they have liquidity risks and occasional vacancy risk (which is nearly eliminated for an owner-occupier). And, the return level we see for homes over time reflects this - returns are very similar to inflation protected treasuries. Actually, I find it useful to treat mortgage rates as a proxy for home returns (in nominal terms, with inflation included), and we know that mortgage rates tend to have a relatively small spread of about 1% above long term treasuries.

I hear pushback regarding this idea from financial advisors. They tend to separate home ownership from other portfolio management decisions. People buy homes because of the benefits of owning, not because they offer high ROI, they tell me. It's consumption, not investment. I realize that there are benefits to ownership and that families don't tend to think of their decision to buy homes as portfolio management. That is because homes aren't commodified like bonds, so as individuals, our focus is on the factors that differentiate one house from another. Very few of us are the marginal buyer, and it is the marginal buyer that pushes homes to non-arbitrage prices.

We tend to live a renting lifestyle where the high transaction costs of housing make it a non-starter until we step over some threshold in our life cycle that puts us in the homeowner category. These things tend to happen in regime shifts, so we tend to hop right over the marginal buyer. This gives us the impression that the marginal buyer doesn't exist. But, that's a false impression. There are some portion of owner-occupiers who are at the margin, and landlords and homebuilders are basically always there.

One other piece of confusion that I want to avoid, which I have mentioned before is the idea of thinking of home values as leveraged purchases made possible with mortgages. This, along with the idea that most households are not on the margin, and would be willing to bid home prices up if they needed to, feeds the idea of a housing market given to irrational booms when credit is loose. But, many households have very high levels of equity. Housing generally lacks price discrimination, so it seems to me that it would be difficult to argue that prices respond to buyers with excessive consumer surplus. The forces at the margin of supply and demand set the prices.

So, I tend to analyze home values from a total equity point of view. Pulling in mortgage factors just confuses the matter. Homes have intrinsic values, regardless of their funding. Now, I confuse this by using mortgage rates as a proxy for required returns on homes. But, I am treating mortgages as another form of real estate ownership with a similar level of required yield, not as a source of funding or demand for the buyer.

This might all seem theoretical, but it is confirmed by the empirical data. Home prices over time follow the path you would expect them to follow if they were a part of an efficient market with relatively low systemic risks. I will look at the data, which I think will include some contrarian findings that I might have called surprising about 40 posts ago.

Wednesday, July 29, 2015

Appraisers are a governor on price fluctuations. They are a source of friction. They can't increase price fluctuations. Nobody with a winning bid on a home raises their bid because the appraisal came in higher. Appraisals are part of what makes home prices sticky.

We don't have banana appraisers in grocery stores, yet banana prices don't just keep skyrocketing upward because of their absence.

Appraisers have been widely blamed for fanning the flames of the housing boom, but even if you don't buy my argument above, accommodative appraisers are not evidence for a bubble. There are two scenarios that could explain the speculative boom.

1) Buyers started bidding up the prices of homes with little concern for their value, accommodated by banks issuing mortgages without regard for the danger of these prices falling back down to reasonable levels. Since the houses were overpriced, banks had to find friendly appraisers who would use aggressive methods to justify the prices that kept the bubble going.

2) Home values were rising at an unusual rate, due to rising rents, rising expected rents, and falling long term real interest rates. Because of the unusual rise in intrinsic values, frictions in the home market made it difficult for market prices to follow. This created an opportunity for "flippers" and speculators who could profit from the price stickiness by buying homes at less than intrinsic value and selling them fairly quickly at an expected profit once the market price overcame those market frictions. Appraisers willing to use more aggressive methods helped to disengage the housing market from those frictions and reduced the inefficiencies that led to speculative profit taking.

Maybe scenario one seems overwhelmingly more reasonable to you. That's fine. The point is, aggressive appraisers will appear in both scenarios. They are a sign of strongly rising home prices. If prices are rising quickly, appraisers will face these dilemmas. Strongly rising prices are not a disputed fact. The fact I dispute is that prices were unhinged from fundamental value. Wherever we come down on that, the behavior of appraisers is irrelevant and is not a sign of a bubble.

Here is a graph from yesterday's post, comparing this measure of housing "yield" to 30 year real treasury yields. These measures of relative yields did not diverge during the boom. They diverged during the bust.

My next post will probably be a new review of historical home values and returns. On the issue of home values, here is a comparison of 20 year TIPS (inflation protected) bonds and homes from the end of 2006 (the worst time to buy a home) to the end of 2014. For home returns, I am using BEA data from Table 7.12, estimating net rental income after all expenses and depreciation (rental income plus net interest expense), and total real estate market values from the Federal Reserve's Flow of Funds report. Housing Yield is that net income estimate divided by owner occupied home market values.

Yields at the end of 2006 were very similar for both homes and 20 year tips bonds. CPI inflation and Shelter inflation were both about 2% in the intervening 8 years, so the experienced income inflation for both of these investments has been similar. But, total returns were 1.8% for homes and 5.4% for 20 year TIPS over those 8 years. Yes, that's right, the total return to the average home bought at the worst possible time - the end of 2006 - has been a positive 1.8%.

Total returns on the average home were undermined by the jump in yield (which moves inversely to price). So, today, the average home yields 3.4% and TIPS bonds yield 0.7%. Keep in mind that shelter inflation at this point is running a full point above broader inflation rates, so in addition to earning 2.7% higher real returns, homes are also pocketing an extra 1% of inflation growth each year now.

As I have pointed out, if there was a housing supply bubble, the adjustment would have been associated with dropping rent income. We have not seen that at all. The bust has been entirely from an increase in yields on homes. This is a sign of a negative demand shock in home ownership. It is important to distinguish between home ownership and housing consumption. These are two different issues, and it seems like pundits frequently treat buying a home as if that is the same as adding a housing consumer. It's not. If anything, it may be adding a housing supplier. Sometimes, observers do treat the boom as an overbuilding phenomenon, but the intervening years have not borne this idea out, since rent continues to rise.

I suppose one reaction is to say that monetary policy has been loose all this time and the 0.7% 20 year TIPS yield is artificially low. First, there is simply no way that the Fed could push 20 year TIPS yields to 3.4% by tightening the money supply. Second, if they could somehow do that without creating a deflationary mess, then TIPS returns in the table above would basically match the average home return. So, over an 8 year period, TIPS bonds and homes would both have exhibited normal behavior in the face of rising real yields - reasonable incomes with small aggregate real capital losses due to the effect of the new yield. So, even the mistaken identification of low long term rate rates and recent Fed policy as loose doesn't salvage the housing bubble story.

We simply have created a period of time where home buyers have been able to capture above-market yields because of regulatory and monetary obstacles to home buying. With a decade long economic dislocation as the side effect. I should have more on this tomorrow.

Tuesday, July 28, 2015

Robert Shiller has a post at the New York Times' Upshot, headlined "The Housing Market Still Isn’t Rational". (HT: Mark Thoma). Robert Shiller seems like a level-headed, intelligent, deeply informed expert. But, it seems to me that his behavioral explanation is leading down a path of sloppy just-so stories.

He says:

If you accept the efficient markets theory — and believe that real estate is an efficient market — then these (KE: rising home) prices are based on “new information,” even if you don’t know what that information is.

The problem with this kind of thinking is that the efficient markets theory is at best a half-truth...

The housing market ...is far less rational than even the often irrational stock market, for a couple of important reasons. First, most investors find it difficult to understand how housing supply responds to changes in demand...Developers and builders will, one way or another, exploit overpricing, increasing effective supply, in that way bringing real estate prices down.

This sounds reasonable, but there are several problems here. First, there isn't a supply response, which is the problem. Here is a comparison of permits issued in San Francisco (annual units/thousand people) and the national rate of permits issued. The major metro areas have, are, and will continue to have constraints on housing supply.

The next graph, which I linked to a few days ago shows rent levels relative to incomes in several major cities. How can someone in 2015 invoke a supply response as a reason for the housing bust?

As unfalsifiable as efficiency can be, what is less falsifiable than claiming that people are irrational? I fear that this predisposition causes behavioralists to settle on behavioral explanations too easily. Here it looks like there are some pretty obvious red flags that Shiller has not bothered to think about.

Do you see the irony here? Shiller complains that there are gullible home buyers who bid up prices to unsustainable levels and implies that people who defend those prices are gullible believers in efficient markets. But, do you see why he says the home buyers are wrong? Because Shiller, himself, is assuming that housing supply is efficient! It's Shiller who gullibly believes in efficient markets for housing supply. Yet, the evidence points to obvious inefficiencies in supply! It was perfectly rational for those 2000's real estate investors to presume that rent inflation would persist. As of 2015, when Shiller is writing this article, the real estate investors have clearly been proven right.

Take a look at the rent graph. In Shiller's version of events, the bust would have come from overbuilding and a collapse in rent. Rent has done the opposite - it has skyrocketed.

Robert Shiller, the efficient market dogmatist, promises supply will pull those rents back down. Never mind that housing starts have been at record lows for a decade along and rent skyrocketing for 15 years. Eugene Fama would blush at the stridency of his unlikely disciple.

But, the further irony is that the thrust of his argument is to undercut supply. Do you think someone reading his article as a guide about whether to buy a new home from a homebuilder is going to be more likely or less likely to fund more housing supply? Do you think the FOMC takes in the consensus view of important economists like Dr. Shiller and loosens the reins on mortgage credit that could fund more supply or tightens them? How big of a difference would it make if, instead of scaring everyone away from funding supply, Dr. Shiller took his message to New York, Los Angeles, San Francisco, etc., and said, "Hey, folks! My theory only holds if you actually let developers build at market rates until rents come down!"?

His second point is structural, which is that short selling isn't possible in housing. I take some issue with this point also, although it is more arguable than the first point. Shorting is common. Think of the bond market. The way you short a bond is to issue a bond and pay the coupon payments on it. Every household that lives in a house is naturally short on housing. We all pay rent (or imputed rent). In fact, as I pointed out in a recent post, homeownership peaked in 2004, and even while first time homebuyers appear to have spiked in 2006 and 2007, homeownership declined. Much as equity markets engaged in regime shifts can see spikes in margin investing and shorting, we saw this in housing. The way we facilitate real estate ownership is like trading equities on a highly leveraged margin - a more bullish long position than anyone would take on equities. The tactical shift of unwinding that position back to renting is just as strong in the direction of going short, and in a way is just as leveraged in the short direction. Since we don't disaggregate our real estate transactions, these tactical shifts are huge, so only a few households selling their homes can have the same effect as hundreds of investors taking marginal tactical short positions on their stock portfolios.

There is a limit to this. Institutions can't easily take large short positions, but the average household has a natural short position of a couple hundred thousand dollars. Many households in places like California can short hundreds of thousands and even millions of dollars worth of real estate fairly easily - actually more easily than they could short equities.

So homeowners are neutral, renters are short, and landlords are long. What we have actually seen in the 2006 to 2015 period is that households are being forced into short positions by a hamstrung banking system, and there are too many organizational and regulatory barriers to institutions taking long positions to counteract that.

And, I hate to be snarky, because Shiller really does seem like a great guy and has read and understood more than I ever will, but then there is this:

There is a way for smart money to profit from an understanding of high prices. It is to build new houses and sell them before prices fall. This is a time-consuming process but it is what we are starting to see now, as housing starts and permits data show.

This is common, not just among behavioralists, but also Austrian business cycle folks, and traders. But, the whole "smart money" idea always rubs me the wrong way. It's presumptuous. And, for instance, here, where Shiller mentions how smart money is responsible for the big jump in building permits, he has missed the apparent cause of the jump, which is a regulatory deadline in New York City that is not likely to lead to persistent strength. The behavioral criticism of efficient markets is basically claiming to prove a negative - that among the vast sea of actors in a market too few of them possessed the wherewithal to push prices to their efficient levels. That's a pretty presumptuous position to take, and it doesn't engender confidence to make claims about what "smart money" is doing that have basic factual errors. There is no smart money in an efficient market.

He ends with an observation on San Francisco, of all places:

In San Francisco, for example, we found that while the median expectation for annual home price increases over the next 10 years was only 5 percent, a quarter of the respondents said they thought prices would increase each year by 10 percent or more. That would mean a net 150 percent increase in a decade. These people are apparently not thinking about the supply response that so big a price increase would generate. People like this could bid prices in some places so high that eventually the local market will collapse. Yet the smart money can’t find a profitable way to correct such errors today.

First, I'm calling shenanigans on the "the average person expected 'x', but half the respondents expected even more, and some much more!" routine. Shiller seems to always shade these things to push the "irrational exuberance" angle, which, again, if you're going to be the appointed guardian against cognitive biases of investors, just doesn't play well. Second, there may be no smarter play in the American economy than betting that San Francisco will not have a supply response to housing demand within the next 10 years. You want to see irrational markets, go sit in on a San Francisco developer's public hearing. I'm a broken record here, but that seems like a pretty big thing to not notice if you're claiming to have insights about how people can screw up market efficiency by being irrational.

But, you know what, the housing market is so efficient that, even though the San Francisco area has shorted itself by hundreds of thousands, if not millions, of housing units, exurbs like Pleasanton and Dublin, and even Las Vegas and Phoenix found a way to entice households into adjusting their real estate portfolios into other places. So all those condos we didn't build in San Francisco were replaced by McMansions in Mesa, AZ and Henderson, NV. And a lot of people, including Robert Shiller, were beside themselves about it, so we killed it. We suffocated it by pulling empty money bags over its head. There can't be any smart money where there ain't no money. And the guy who sees inefficiencies everywhere but where they are congratulated us for it, and we congratulated him back. "See! We knew it!", everyone tells each other. We're in this mess because of them, the people growl. I think these behavioralist interpretations are technically wrong. But, in the end the damage is behavioral, creating unnecessary and damaging public demands against the very thing we need - supply and access to ownership. The behavioralist misinterpretations create irrationality where it can really dig in and create persistent inefficiency - public policy. Maybe the next movie about the housing bust should be by Charlie Kaufman.

How much credence does Shiller's presence give to the false notion that our biggest concern is high asset values? What if that is wrong? What if asset prices aren't too high? What kind of damage is being done by machinations to bring them down? I mean, if asset prices don't reflect a 20 year run of irrational demand, then think of what we have to do to beat them down? We have to beat ourselves down. There is a huge cost here to being wrong. Here is a graph comparing net rental income on owner-occupied homes to real rates on long term treasuries. This graph looks to me like it shows a housing market that was arbitraged pretty efficiently with real bond rates until 2007. (All the lines but the blue housing line are proxies for 30 year real treasury rates - accuracy, in order from most to least is: green, red, purple.) Remember high rates mean low prices. And Shiller is posting articles in the New York Times about how the housing market is inefficient...because prices are rising too high?! Arbitrage profits have only been available in housing since 2007 - by buying them. Those profits are available because of the limits to going long on housing - because so many owner-occupiers can't get mortgages and because institutional buyers are building organizationally from such a small base.

PS. There is an adjustment I wanted to look at on the long term Home Price Index Shiller keeps. I feel like I'm being irrationally exuberant myself by taking issue with some of these things. After taking him to task, it would serve me right if a reader finds that I made some basic algebraic error or something. And, Dr. Shiller is very generous about making data public, which I have gotten much value from myself. But, I have noticed that the long term real home price index that people use to demonstrate how irrational the 2000s housing market was is adjusted using CPI for all items. It seems more appropriate to me to use Shelter inflation, which we have going back to 1953. If rents are inflating at a different rate than other items - and why wouldn't they - then wouldn't rent inflation be the right metric to deflate home prices by?

And, there has been an ongoing problem, which I think has generally been a late 20th century problem (and after) of creating artificial housing scarcity in our large cities. This creates ever higher rents in these areas, which leads to persistent rent inflation, the rate of which is determined by the substitutability of real estate outside those areas for the prime real estate. So, we might expect real estate in Oklahoma to inflate at more or less normal levels, but there will be some level of rent inflation in the cities that will accumulate over time.

And talk about inefficient markets. Places like New York and metropolitan California have policies explicitly set up for inefficiency. People in those cities work, with passion and moral fervor, to make sure that money cannot purchase real estate in their cities. Money is the thing they don't want you to offer them for their real estate.

So, here is the chart from the file Dr. Shiller makes public. I have added Shelter inflation from 1953 onward, and added a line to the chart of Real Home Prices, adjusted for shelter inflation instead of broader inflation.

The difference between that blue line and orange line is a decent estimate of the real wealth that has been sucked out of productive hands by overzealous zoning and building restrictions - transferred to current and past real estate holders. It could be that about 1/3 of the value of our housing stock has come from artificial barriers to building. This represents income we transfer to landowners for the purpose of not housing us. The way we fix it is by building in the major metro areas. Yes, that will be a windfall for some landowners. But, the choice is between windfalls for providing value or windfalls for not providing value.

PPS. Shiller referenced an Ed Glaeser paper in his article. Glaeser has some really great papers that I need to catch up on. The paper Shiller references is about historical episodes of housing booms and busts. But, if I read Glaeser right, he says that most of those cases, in hindsight, are much like my reading of the recent boom. The boom valuations were justifiable in looking at subsequent rents or profits and the busts were a product of the optionality of leveraged real estate, where banks get left holding the bag. So the problem is mostly the busts, not the booms, and the busts are related to the design of our financial institutions which leaves real estate markets dysfunctional when there are sharp downturns. Another great Glaeser paper, and another. Glaeser has made many of the points I have been making here recently. An example of the differences between he and Shiller: Shiller ends his New York Times piece with, "The bottom line is that there is no reason to assume that the real estate market is even close to efficient." In that last link, Glaeser and his co-authors begin their conclusion, ﻿﻿"Home building is an enormously competitive industry with virtually no
natural barriers to entry."

Monday, July 27, 2015

Bankruptcies of mortgage originators began building up in early 2007 and funds with leveraged investments in subprime-based securities were collapsing throughout 2007. This was when delinquencies were really only beginning to rise from boom-time levels. Delinquencies in mid 2007 were in the ballpark of delinquencies in 2001 which was not considered to be a particularly poor housing market. But, one thing that had begun to happen by mid-2007 was an unprecedented collapse of home prices.

I think everyone has generally assumed that the collapse of hedge funds and investment funds in 2007 was due to the combination of (1) high default rates on collateral and (2) high leverage in the funds that left no room for error. Default rates were rising at the time, but they weren't outrageously high yet. But, these were securities with market prices. Actual cash flows on securitizations from 2006 and 2007 would have been low because of defaults. But, because the defaults were being triggered by unprecedented widespread nominal drops in home prices instead of by more typical causes of defaults, the effect on securities prices may have been especially pernicious. Potential buyers of an MBS experiencing high defaults because of a poor labor market would price in an expected recovery. But, in mid 2007, someone valuing an MBS with high defaults would look at home prices off 10% and accelerating downward, and they may have modeled very high future default rates into their valuations. Markets are forward looking. So, even before defaults reached their high levels, the market values of MBS's may have been collapsing because of expectations of the ongoing collapse in home prices.

There has been extensive discussion about how the models used to rate securities backed by subprime loans were flawed because they didn't account for the potential for correlated defaults. But, I suspect that the collapse in the market values of those securities happened before most of the actual defaults. And, if that was the case, then an expected recovery in home prices in mid 2007 would have had tremendous benefits.

And, here we reach the circular problem with the crisis. If we don't assume that home prices required a massive correction, then large-scale monetary and credit market support in 2007 seems reasonable, even obvious. Markets in 2007, in effect, may have pulled the imminent collapse in home prices back in time from the near future to the present, reflected in the collapsing prices of MBS's, and a change in those expectations would have been significantly helpful. But, if we do assume that home prices required a massive correction, then that support seems dangerous. And, in this way, the crisis became self-imposed.

At the August 2007 FOMC meeting, after many bankruptcies and fund collapses, including the Bear Stearns subprime hedge funds, the FOMC statement was still reporting to anyone who might have been valuing an MBS that "the housing correction is ongoing" and the "Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected." Home prices were nearly 10% from their peak in nominal terms, already unprecedented in modern American financial experience, the Fed Funds rate was still pegged at its high of 5.25%. And the 2.1% core CPI inflation that the Fed was worrying about consisted of 1.2% non-shelter inflation and 3.4% shelter (i.e. rent) inflation, which had jumped up in 2006, apparently in reaction to the supply shock when homebuilding collapsed.

---------------------------------------------

The legend is incorrect. The scale for housing starts is noted on the axis.

If we break out inflation by tenure, I think we get a picture of the problem. From the mid-1990s until the early 2000s, rent inflation was high. Renter inflation tended to be higher than owner equivalent inflation (OE Rent). This reflects the sharp supply constraints we have seen in the core metro areas since the 1980s. As the recovery in housing starts built up in the late 1990s, multi-unit starts failed to recover as they had in previous decades. So, as housing expansion recovered, I think what we see in the inflation data is the rising cost of renting driving households from multi-unit housing in the cities to single family homes outside the cities. In the 2003-2005 period, single family home building finally rose to a level that accommodated all of this housing demand. So, we still see the pricing pressure in rental housing, but total housing inflation is moderate.

Now, keep in mind, this period does look like a boom in single family homes, because in order to meet aggregate housing demand, the SFH market had to expand enough to accept all of the households who have been locked out of metropolitan multi-unit housing.

In 2006, housing starts collapsed and rent inflation shot up. This looks like a clear indication of a supply shock, and the trend shifts are sharp. This also happened to coincide with the inversion of the yield curve, which correlates negatively with bank credit growth and has been a leading indicator, with about a 1 year lag, of recessions.

In 2007 and 2008, housing starts continued to collapse, but now so did rent inflation. This suggests that demand was suddenly collapsing more strongly than supply. During this period, renter inflation pushed far above owner equivalent inflation as the breakdown of mortgage credit and home ownership markets pushed many households back into rental housing.

Since 2011, we have the worst of all these factors. Housing starts remain at extremely low levels, and shelter inflation is again somewhat high. But, extremely low demand is keeping rent inflation from exploding. If demand recovers, I think we should expect single family home construction to recover with it, keeping owner equivalent rent from jumping. The significant expansion of a rental market in single family homes is helping to keep renter income low and is probably causing more of the renter inflation to be reflected in owner equivalent rent, but continued supply constraints in the major metropolitan areas are continuing to put upward pressure on renter inflation.

Friday, July 24, 2015

One version of the housing bust story says that one source of the problem in the housing boom was the increasing tendency of banks and mortgage brokers to troll for households of lower and lower credit quality and to use the expanding generosity of the GSE's to ultimately stick taxpayers with the credit risk. Respondents, usually from the political left, argue that the public mortgage agencies didn't play a large role in the boom. I think the data does bear out the GSE defenders.

I will begin my comments by using this portion of a Wikipedia article as a summary of perspectives on the crisis (see the article for quotation attributions). First, defenders of the GSE's point out that there was a "bubble of similar magnitude in commercial real estate in America" which would be unrelated to GSE's and public homeownership policies. Others report, "We find limited evidence that substantial deterioration in CMBS [commercial mortgage-backed securities] loan underwriting occurred prior to the crisis." And others note, "most of the commercial real estate loans were good loans destroyed by a really bad economy. In other words, the borrowers did not cause the loans to go bad, it was the economy."

The defenders of the GSE's are correct on all of these counts. The irony is that these are similarities between the commercial mortgage market and the residential market. In fact, shouldn't this defense of the GSE's be a prema facie criticism of the conventional narrative of financial crisis? I mean, if commercial mortgages had an almost identical rise and fall as residential mortgages, without a subprime component, and with a bad economy triggering the bust, shouldn't we have a strong presumption that both markets shared causal factors? Logically, the behavior of CMBS tends to argue against both the GSE's as a cause of the bust and subprime loans generally as a cause of the bust. Isn't it interesting that CMBS are only deployed to defend the GSE's, but not subprimes in general?

Notice that total mortgage growth was not particularly unusual in the 2000s. The growth rate at the top end of long term ranges reflected the influence of low real long term interest rates. But, as I have chopped through the weeds of this topic, I have found that the germ of this idea that there was a problem - a "bubble" - came from the rise in individual home prices, which is largely the result of housing constrictions in the large core cities. We have misinterpreted a supply problem as a demand problem. As a start, note that even at the end of the boom, there was nothing particularly unusual about the rate of residential or commercial mortgage growth compared to a half century of experience. And the 1990s had seen the weakest growth for both types of mortgages in the modern era.

Critics of the GSE's, in the Wikipedia article, point out, "[f]rom 2004 to 2006, the two [GSEs] purchased $434 billion in securities backed by subprime loans, creating a market for more such lending." Further, "In 2003, after the use of subprimes had been greatly expanded, and numerous private lenders had begun issuing subprime loans as a competitive response to Fannie and Freddie, the GSE's still controlled nearly 50% of all subprime lending. From 2003 forward, private lenders increased their share of subprime lending, and later issued many of the riskiest loans. However, attempts to defend Fannie Mae and Freddie Mac for their role in the crisis, by citing their declining market share in subprimes after 2003, ignore the fact that the GSE's had largely created this market, and even worked closely with some of the worst private lending offenders, such as Countrywide. In 2005, one out of every four loans purchased by Fannie Mae came from Countrywide."

It sounds like there was a surge of securitization activity in the 2000s, especially after 2003, as GSE's stretched their standards in order to compete with the recklessly expanding private market. So, what does the data look like? I am using the Federal Reserve's Mortgage Debt report for data.

Securitized mortgage financing had increased in importance from the late 1960s until about 1994, after which it leveled off as a proportion of mortgages outstanding. At about the time that the trend in homeownership rates sharply shifted up, a few years before the price boom began, securitization plateaued as a proportion of mortgages, and only rose slightly as a proportion as a result of the collapsed banking sector after 2006.

In the next graph, we can see the growth rates of mortgages retained by the banks and securitized mortgages. The growth rate of securitized mortgages outpaced bank mortgages until 1994, after which both types of mortgages grew. In fact, from 2003 to 2006, mortgages retained by the banks tended to grow faster than securitized mortgages, and grew much faster than mortgages securitized through Federal Agencies and GSE's (the light purple line). Including Ginnie Mae securities, total mortgages through the public agencies barely grew in 2004 and 2005. Can you believe that 2004-2005 saw the least expansion in public mortgage securitizations since those programs had begun? (We've managed to match that record every year since 2010.)

In the next graph, total mortgage growth is shown, with the portion of total growth broken out by bank-retained, securitized, and other. I have also included the yield curve slope (10 year treasuries minus the Fed Funds Rate) here (the black line). There is a persistent pattern here that when the yield curve is steep (10yr-FFR > 1%), bank retained mortgage growth increases, and when the yield curve is flat or negative (10yr-FFR < 1%) bank retained mortgage growth declines. Well, this was the case until 2008.

We can see in the previous graph of growth rates that securitizations and bank-retained mortgages have tended to grow inversely with one another. This suggests that the securitization agencies have helped to reduce cyclical fluctuations in mortgage credit. And, they continued to do that in the 2000s.

Here are graphs that are replications of the graphs above, except that the agency and mortgage pool holdings are broken out between those facilitated by public agencies and private pools (line 69 in this table). If we take private securitizations out of the picture, there was a very brief and quite normal boost in mortgage growth from 1999 to 2003, followed by a return to the low growth levels of the 1990s.

The next graph is a graph of the size of mortgage pools backed by each agency plus private pools. (Be careful with interpretation. I used a log scale so that steady growth is linear.) Here, we can see again that total mortgage securitizations outstanding were growing at a new, lower trend that remained fairly linear going back to about 1990. Agency pools (including Ginnie Mae), in total, declined from trend slightly after 2003, as did both Fannie and Freddie, individually. Ginnie Mae declined sharply.

In October 2005, the GAO issued a report to Congress, titled "HOUSING FINANCE
:Ginnie Mae Is Meeting
Its Mission but Faces
Challenges in a
Changing Marketplace". It includes this statement (page 16):

Since 2000, Ginnie Mae’s volume of MBS outstanding has fallen from $612 billion to $453 billion in 2004, a drop of approximately 26 percent. The primary factor contributing to this decline has been the increase in borrowers who have refinanced out of FHA and VA loan programs into conventional loans. Falling interest rates and rising home prices have led to a boom in refinancing over the last 10 years, particularly from 1997 to 1999 and 2001 to 2004. At the peak of the refinancing boom in 2003, refinancings represented about 65 percent of mortgage originations. As some borrowers with mortgages insured by FHA and guaranteed by VA have built up equity in their homes, they have been able to refinance out of these programs into conventional loans that may offer more favorable and flexible terms and interest rates.

The rise in Freddie and Fannie balances until 2003 were balanced out by declines in Ginnie Mae balances. Ginnie Mae is the agency that specifically issues FHA loans which are not and never were conventional. These were loans that were always issued with low down payments. Some of the long term decline in the importance of Ginnie Mae has come from the growth of private sources of subprime mortgages and from competition with Fannie and Freddie. But, the primary shift in securitized mortgages during the boom was out of Ginnie Mae mortgages by refinancing into more favorable terms and with higher levels of equity, because of the significant capital gains, which presumably tended to relieve borrowers of the mortgage insurance fees that come with FHA loans.

Now, there certainly was some equity withdrawal going on there, and probably some households that only avoided default because they were tapping marginal new equity - possibly a small portion of those fed into subprime loans instead of conventional loans. The fact remains - in total, all the federal agencies and GSE's had no unusual growth, and, in fact, declined from trend after 2003, when balances at Freddie and Fannie leveled out and Ginnie Mae continued to decline.

So, we have two distinct phases. Through 2003, traditional securitizations grew at their regular pace and marginal new mortgage growth came from mortgages retained by the banks. After 2003, growth of the GSE and agency portfolios collapsed and new growth came from the new private securitization market.

But, as I have with other issues here, I am going to push back against the idea that this was a "subprime bubble". As with so many issues here, through the haze of chaos, the bubble narrative hits all the right buttons, and honestly seems to make too much sense to deny. But, when we look more closely at the details and the timing, there are many pieces of evidence that don't fit the narrative well at all, or that present mysteries.

1) The rise in the homeownership rate pre-dates the price boom in general. Most of the rise in ownership happened before the 2001 recession and it peaked in 2Q 2004, before the subprime phase kicked in. There is no connection between the growth of the private securitization market and growth in homeownership. In fact, homeownership rates were declining as private securitizations shot up.

2) In the face of this massive increase in non-conventional mortgage securitization, the evidence points to surprisingly stable buyer characteristics - whether incomes, loan to value, FICO scores and whether the data is for national first-time or repeat borrowers of prime loans, for subprime borrowers, or fornationalsurveys, borrower characteristics are surprisingly stable for all groups given the tremendous changes in originations during the period.

3) There is no apparent relationship between housing starts and subprime mortgage levels. Housing starts rose steadily through 2005, then collapsed sharply. Subprime loan balances continued to grow until the middle of 2007 with no interruption at all.

4) Rent inflation has been high for at least 20 years. As housing starts peaked in 2004 and 2005, rent inflation finally moved down to around the Fed's 2% target level, suggesting that during this period, homebuilding was only just beginning to match demand for housing. When housing starts collapsed in 2006, rent inflation immediately shot back up to over 4%. Oddly, the high level of private mortgage lending didn't help to maintain housing starts even in the face of this clear signal of a supply shock. Note that owner-occupied rent inflation subsided along with subprime mortgage balances and home prices in 2007, as the collapse of credit markets caused demand to drop along with supply. But rent inflation for renters remained high even into 2009.

5) Home prices peaked at the end of 2005 along with housing starts, also with no correlation to the rise in private securitizations.

6) Among prime mortgages, at least, repeat buyers declined after 2003 and first time buyers increased. First time buyers increased especially sharply in 2006-2007. This sits oddly with the fact that ownership peaked in 2004. There had to be tremendous churn of households exiting homeownership during this period.

7) The private securitization market grew by about $1.1 trillion between the end of 2003 and the end of 2005. This was the steepest period of home price increases. During that same period, household real estate market values increased by about $6.7 trillion. An increasing share of this was due to investors. That is implied by the declining homeownership rate and strong housing starts, and confirmed by Survey of Consumer Finances survey data. At the end of the boom, coincidental with the rise of subprime and private securitizations, home values were increasingly equity based and investor-driven.

8) While equity levels had slightly declined until 2003, they slightly recovered during the subprime phase, only falling when home values began to collapse. This is especially surprising given the large amount of churn that was taking place in home ownership. First time buyers, which appear to be a large part of the buyer's market in 2004-2007 are typically at their highest leverage level, and home sellers would tend to have more equity, especially in a market where prices had been increasing by double digits for several years. Yet, despite these pressures, equity levels were healthy until home prices collapsed.

9) The private securitization phase didn't begin until after ARM rates began to rise. Much of the additional private securitization balances occurred when ARM rates were already at their maximum levels. Private securitizations and subprime mortgages were still a small portion of the market when ARM rates were low. Private securitizations continued to grow as a proportion of the mortgage market until the middle of 2007, which was a year after ARM rates peaked.

One facet of this to think about is that this tremendous churn in owners belies the notion that homebuyers max out available credit, and that loose monetary policy or credit markets will lead households to mindlessly bid up assets. Even though home prices continued to rise until 2005, there had to be extensive downward pressure from the sellers that were exiting home ownership. And, after 2005, that pressure became so great that housing starts collapsed and home prices began to fall, even though mortgage funding continued to grow until mid 2007. Obviously, access to credit is an obstacle to demand for home ownership, so that fewer constraints will be associated with some buying pressure. But, why should we believe that, even given excessive access to credit, households will bid up the prices of houses with no regard for value. Even if there are some marginal buyers willing to do that, there will be many sellers who will counter that demand. There appear to have been many of those sellers in this case. Maybe we can take the healthy level of existing home sales in 2004 and 2005 and the large amount of owner churn as a sign that many owners considered home prices to be above intrinsic value. Existing home sales began to collapse in late 2005, suggesting that the extreme price declines in 2007 were from the collapse of demand, not a surfeit of sellers. I am not going to fully work it out in this blog post, but it appears to me that, if the strong appearance of sellers in 2004-2005 was a reaction to excessive market values that this natural market reaction was happening when aggregate intrinsic values and market values were still within a few percentage points of one another.

-------------------------------------

Considering the relatively broad base of defaults, in terms of credit quality, it seems likely that even the evidence that conventional securitizations experienced lower defaults than private securitizations includes a bit of statistical confusion. Private pools held an especially large portion of new originations when the bottom fell out of the housing market and pulled so many households underwater. Young mortgages are especially vulnerable to a nominal shock, even with responsible underwriting. Defaults in the private pools would have been worse because defaults in 2006 and 2007 vintage mortgages were worse for all types of mortgages.

This same effect would apply to high default rates among ARM loans vs. fixed rate loans. ARM loans were especially popular at the end of the boom, so much of the excess defaults for ARM loans vs. fixed rate loans could be a product of loan vintage. The idea that ARM mortgages would have higher defaults because they were taken out by more reckless borrowers seems to make so much sense. But, remember, the high default vintages were taken out when short term rates were at their peak. If anything, ARMs in those vintages saw actual rates below what the borrowers had expected to see.

D & VH, Figure 3

D & VH, Figure 4

This is what Demyanyk and Van Hemert found. Regarding these graphs from their paper on subprime mortgages, they say:

"It is important, though, to realize that this result (KE: the higher defaults of adjustable rate loans after 2005 compared to fixed rate) is driven
by an aging effect of the FRM pool, caused by a decrease in the popularity of FRMs from 2001 to 2006. In other words, FRMs originated in 2006 in fact performed unusually poorly (Figure 3,
upper-right panel), but if one plots the delinquency rate of outstanding FRMs over time (Figure 4, left
panel), the weaker performance of vintage 2006 loans is masked by the aging of the overall FRM pool."

The pundits on the left are correct. Fannie and Freddie aren't to blame. They are also correct that commercial real estate went bust as a result of the economic bust, not the other way around. Pundits on the right are also correct - that predatory banks were not systematically pressing marginal households into oversized homes. Everyone is correct about the whole mess except for believing that the other side is wrong and that a bust was necessary or inevitable.

Can we all just have a group hug and start letting middle class families buy houses again?

Thursday, July 23, 2015

I have pointed out that real housing consumption has been in a long term decline. In a post, today, Political Calculations, points out how the rise in home prices as a function of incomes is coming from higher rents. In other words, the source of the high cost of owning a home is the high cost of renting a home.

This is a little tricky. What this means is that the value of some homes, over time, is rising due to a lack of supply. For the household living in the house, the house value appears to remain the same. But, since the real stock of homes is declining, relative to incomes, other households, on average, are slowly reducing their housing consumption. Owning a home in this context is kind of like being in a lineup when they ask volunteers to step forward, and everyone else steps back. Renters in market-priced housing notice this naturally, as their rent rises each year, and they will tend to adjust their housing consumption over time account for the changing values. But rent-controlled tenants and home owners are insulated from this information.

If housing markets were perfectly liquid, we would sell off a few square feet of our homes each year in order to account for the stagnant aggregate supply. But, since we can't do that, buying a home includes a pre-commitment to increase our nominal housing consumption each year that we live in the house.

This is even more tricky because most of these changing values are related to the value of location, so the change in values is somewhat invisible to us. This is basically what is happening in places like San Francisco's Mission District. The high demand for San Francisco housing, along with the long term constraints on building, has meant that households who moved there years ago when it was not so in demand have been passively increasing their housing consumption continually over the past few decades so that now middle and low income households are occupying housing that is more fitting for very high income households. This causes all sorts of consternation, because part of the value of those homes came from the flavor of the neighborhood itself. This is real value, and it is value with significant sentimental and emotional character. The dislocations caused by this change are frustrating.

So, even though location is the main source of changing home values, it is easiest to think about this in terms of size. What has happened to those households in the Mission District is conceptually similar to having added 100 square feet to their homes every year for the past few decades. We sympathize with the tenants, because they didn't ask to have the equivalent of 100 square feet added to their homes each year. It just happened to them. But the fact remains that they are over-consuming, and there is no getting around that.

As sad as those changes are, dislocations caused by changes in the world around us are just as real as changes that we instigate. The streets of San Francisco used to be filled with horse drawn carriages. The world changed. If there was a group of Amish people living in a neighborhood in San Francisco who still wanted to be able to drive their horses downtown to shop, we wouldn't be able to accommodate them. San Francisco isn't built for horses any more. San Francisco changed. At some point there probably was a bitter fight between the remaining horse and buggy households and the rest of the city. And the horse advocates would have had sentiment firmly on their side - rightly so. But, their loss was, sadly, inevitable.

The plight of the families in the Mission District is especially noticeable because city policies have pushed much of the added cost of their housing consumption onto their landlords so that the disconnect between their actual housing consumption and their perceived housing consumption has grown to outrageous proportions. But, really this is the dilemma that homeowners face when location value is changing. Homeowners don't have rent control laws, but they simply mentally benchmark the nominal rental value of their homes to the values they had when they purchased them. The added rental value of a home in a supply constrained location isn't as obvious as that hypothetically added 100 square foot room, so there becomes a growing disconnect between the value of a home to the owner-occupier and its market value.

But, it gets even trickier here. For a household in a home with a stable rental value, there is an endowment effect to owning. The home gains value to the owner simply as a function of the time spent living there and the place that home has in a family's history. For a household that owns a home with stable rental value, the market value of the home remains stable, but the household keeps gaining more consumer surplus over time as the endowment effect of living in the home accumulates. We see this very clearly in high profile eminent domain cases where homeowners fight to keep their homes even when the offering price is well above the market price.

So, when a household buys a home in a market with constrained supply, the added rental value of the home, which they are consuming over time, is simply coming out of the consumer surplus that would be building up as a result of that endowment effect. For most families, if they don't engage in a transaction with their home, there is really no way to notice the difference between living in a home where rising imputed rent is capturing the consumer surplus and one where it isn't.

The problem the families in the Mission District are having is that market values have outpaced the endowment effect. And the emotional dissonance is amplified by the fact that the consumer surplus was being claimed by the tenants but the market gains will go to the landlords.

Anyway, back to my original point. Where this makes housing markets difficult to intuit, and where it makes reasonable home prices look like a "bubble" is that the effect of all of these complex conceptual issues is to raise the prices of houses today in markets where supply constraints are expected to remain strong. In order to buy a home in, say, San Francisco, a household has to pre-commit to paying a rising imputed rent to reflect ever increasing real home consumption that the family doesn't intend to actually initiate, and that they won't notice when it happens. The household is pre-committing to taking less of the endowment effect of living in the home as consumer surplus, and when they purchase the house at today's market price, they are transferring much of that consumer surplus to the home seller as a part of the market price today.

It seems like home prices in cities with rising rents are disconnected from reality, but what we are really seeing is a transfer of expected future consumer surplus from the buyer to the seller. Is that confusing enough for you?

To me this is an example of the amazing ability of market values to convey information. To own a home in a supply constrained city, you have to accept that there will be dislocations in your housing consumption that will be caused by the city's inability (or unwillingness) to accommodate changing housing demand. This will change the nature of your home even while your housing needs remain the same. These changes cause the expected value your home will have to potential other tenants to be higher. Since markets have such incredible power to accommodate these values even though the individual buyers and sellers have no understanding of the complexity of the issue, we end up, amazingly, bidding up the prices of homes to their correct values.

The problem arises because politics only incorporates our conscious understanding of what we are transacting, and we impose political impositions against the very transactions that we freely engage in. Thus, we have the strange presence of people who purchased homes in the 2005-2007 period and who simultaneously hold the view that there was a housing bubble created by predatory banks and out of control speculators. This is an understandable position for them to have. There is absolutely no way that we could expect ourselves to understand even a remotely small part of the inputs into the market price of any given good. The gap between the ability of the market to accommodate that information and our own understanding is cosmic. It's miraculous. The problem lies in the fact that we have such effective outlets for the imposition of our conscious understanding on those markets. The problem isn't that those people are exhibiting some sort of hypocrisy. To expect any more from any of us would be ludicrous. The problem is that they vote and that their votes actually change things.

So we have voted ourselves a supply problem and then we voted ourselves a demand problem. We look at these amazing networks of coordination, and where the outcomes don't always align with our sentiments (why in the world would they), we accuse, "See that! Capitalism did that." The Pope calls it the "dung of the devil". And we cheer. My point isn't that markets achieve some sort of moral and distributive perfection. The point is that we are in no position to judge. As Mencken said, "Explanations exist; they have existed for all time; there is always a well-known solution to every human problem — neat, plausible, and wrong." and "The fact that I have no remedy for the sorrows of the world is no reason for my accepting yours. It simply supports the strong possibility that yours is a fake." These statements are horribly true. And I have no solution for the problems they do not address. What kind of monster would I be to suggest that we replace some of our non-solutions with a lack of solutions. As a compromise, I try only to advocate against our non-solutions when they are causing clear and identifiable harm.

Scott Alexander had a great post where he pointed out the problem of diagnosis in the face of uncertainty. If intervention is called for 10% of the time, and we have a 90% success rate of intervening correctly when we need to, we will intervene twice as much as we should.

We see 1% of the unaddressed problems, which can be awful and are naturally the hardest problems to address. And we naturally want to demand more interventions. But, this is the libertarian problem. Those Mencken statements seem crass and fatalistic. But, we are optimistic. We are saying, good for us! We have an amazing 90% success rate in diagnosing the worst externalities and problems of these amazing markets that coordinate far beyond our ability to understand what we are doing. This is much better than we could possibly expect of ourselves. Now, given this outstanding success rate, it follows that for every new intervention that we have missed, there are 9 interventions that we have mistakenly imposed.

So, please understand, an anti-interventionist approach may be predicated on an extreme, even indefensible, optimism about our ability to intervene effectively.

PS. How bad could those incorrect interventions be? Just think of whatever policy the political party you don't favor is pushing in the next election. Human sacrifice throughout history was frequently considered a good idea. We can pretty easily get into Godwin's Law territory here. Interventions can very easily escape moral mean reversion. If only we had a tradition for worrying about interventionist speculative bubbles.

Tuesday, July 21, 2015

Playing around with employment stats this weekend, I noticed an interesting pattern. Non-supervisory employees tend to be laid off more cyclically than other employees. So, the proportion of employees who are production and non-supervisory tends to be a mirror of the unemployment rate. I think this ratio might give us a window into the business cycle. There have, unfortunately, been few times where we have been moving ahead in a relatively calm equilibrium state. Most of the time, we are moving through cyclical disequilibrium.

This ratio suggests that we have entered a period of calm, where we have re-established economic stability. (Corporate earnings signal this also.) Now the question is how long we can maintain this.

I have included short and long term interest rates in the graph because we can see that cyclical declines in non-supervisory employment generally happen when the yield curve inverts. Before the 1980s, when the Fed was biased to inflation, interest rates would tend to rise after equilibrium was reached, and the Fed Funds Rate would chase long term rates up until they went too far. Since 1980, long term rates have tended to move sideways, but rising unemployment has continued to coincide with the inverted yield curve. Unless we see long term rates move up sharply, I don't see any reason why we need to tempt fate here.

I have also included an inverted graph of the unemployment rate, scaled to line up with the ratio of production and non-supervisory workers to total workers. I think it is interesting that secular shifts in the unemployment rate have moved together with this shift in this ratio. This also seems to coincide with shifts in the Beveridge Curve.

Interestingly, P&N-S workers appears to have peaked, and has moved to a higher level than the previous recovery. This suggests that the Beveridge Curve should remain to the left and that the unemployment rate should be lower. But, recently job openings have been very strong, which suggests that the Beveridge Curve is shifting to the right.

I would associate a lower secular unemployment rate and a leftward Beveridge Curve with less friction in the entry-level labor market. Either my priors are being overwhelmed by other issues, or we are getting mixed signals. I think there might be two issues here. (1) Hysteresis in labor markets which create persistently higher unemployment after extreme corrections (like in the 1980s, where unemployment leveled out for a few years) and (2) the continued categorization of about 1/2% of the labor force, who have been unemployed for more than 2 years, as unemployed instead of marginally attached. If these are explanations, then we may see unemployment dip below 4%, if we are willing to let it. (It's already under 5% after adjusting for these marginally attached workers.)

Could the persistent level of unemployment (which is not reflected in continued unemployment insurance claims, either today or in the mid 1980s) be a product of a cyclical correction that was deep and long enough to reach past entry level and low-skill employees? Maybe firms have made cuts in their organizational capacity, which take longer to re-establish. Here I have charted unemployment by education, indexed to January 1997 when unemployment was at 5.3%, as it is today. Unemployment for "less than high school" workers has recovered, but unemployment for high school and college educated workers is still above the January 1997 level (the same goes for the "some college" category). Again, I think that if these factors are in place, then there is a lot of room for strong top line economic growth, and, in fact, allowing this growth to happen is integral in re-establishing the foundation for future real economic expansion.

In fact, it may be dangerous to use wage growth for production and non-supervisory employees as a signal of Fed policy, because if that category is the one which has recovered, we may need to see some wage inflation there in order to complete the recovery in non-production employment.

Using these indicators, here is a graph which shows the Production Employee/Total Employment Ratio along with a measure of Yield Curve Inversion and a measure of S&P500 corrections (both real and nominal).

In terms of defensive equity tactics, this ratio may be better than the unemployment rate itself because the change in trend looks like it tends to be sharper. (Red marks show when there is a yield curve signal, green when there is an employment signal, and purple when they both signal a correction.) This seems like something to make note of.

On the theme of "We are the 100%.", I think the Real S&P500 measure shown here is informative. In real terms, from 1968 to 1982, the S&P 500 was down 60%. High inflation during the period hides the terrible performance of productive asset valuations during the period. This period of terrible equities performance coincides with low real wage growth and declining employment of production and non-supervisory workers.

Then, in the late 1980s and 1990s, equity values grew in both nominal and real terms and real wages and employment of production and non-supervisory workers also grew.

There is an additional adjustment that wasn't important for my trend changing signals here, but is important for long term comparisons, and that is the fact that capital returns through buybacks cause stock price indexes to rise relative to capital returns through dividends. Buybacks have been utilized widely since the 1980s. If I adjusted the S&P 500 both for inflation and for buybacks (so that the index price reflected the counterfactual where all capital is returned through dividends), the S&P 500 would still be about 20% below its peak. In fact, the past 15 years has been a difficult time for equity holders. Remember that in the 1970s, owners received upwards of 3% to 5% in dividends. During the 2000s, that level has been more like 2% (the rest coming through share buybacks). So, real, buyback adjusted returns on equities look much like they did from 1968 to the mid-1980s.

But, during this period, real wage growth has been fairly strong and production and non-supervisory employment has been strong. Political rhetoric is drowning in class warfare these days, but this has nothing to do with anything that is happening in capital markets. The story is really closer to the opposite of what our political battles are about these days. Capital is being left behind. Or, I should say legacy capital is being left behind. Some of what is going on is that revolutionary changes in technology are causing much of the gains to capital to be through disruptive capital, so that existing shareholders aren't capturing the gains; Silicon Valley entrepreneurs and key employees are.

Real wage growth has been especially strong when we account for
the supply-side constraints in housing that capture some of those gains.

So, clearly, in both cyclical and secular terms, we are the 100%. The fortunes of the lowest income workers and of corporate owners move together. And, if anything, the fortunes of capital are the leading indicator. That is what makes equity macro-speculation difficult. Few indicators lead equity values. And, this is why cynics who spit at the Fed for the "Greenspan put" and who complain about how the Fed is just keeping the stock market from having to take a loss are so, so damaging for our economy. There is tremendous political pressure for the Fed to avoid looking like it is just protecting Wall Street. But, equities are a great leading indicator for what sort of damage is about to hit production and non-supervisory workers. Equities are a great indicator for whether the Fed is doing its job well or not.

And, in the end, I think this solves a bit of an Efficient Markets Hypothesis problem. How can the yield curve be such a seemingly good forward indicator? And, how can equity cycles appear to have such momentum? It's because the money supply isn't controlled by the market. It's controlled by a committee which, even though it is somewhat insulated from year to year political upheavals, is nonetheless vulnerable to some public pressure, and that pressure is very strongly pro-cyclical.

And a lot of that pro-cyclical pressure comes from anti-capital and anti-market biases which lead people to promote wholly destructive policies when it appears as if positive policies will benefit capital.

Imagine how absurd it would sound to complain that the Fed was managing the money supply with a "Production and Non-supervisory employment put". That would be a pretty stupid complaint. Stable wage growth is, in fact, an ideal target that Scott Sumner mentions. Guess what. It's almost exactly the same policy as the "Greenspan put". People who think we are in bubbles, who equate significant asset collapses with optimal Fed policy might as well be salting our fields. That policy and its effect is implicitly and explicitly the same and it affects both the top and the bottom of the income scale.

These errors seem pretty mainstream these days. Of all the anger being aimed at the Fed, little of it is aimed at the fact that they let equity and real estate values drop by shocking amounts or that they were still engaging in discretionary hawkish decisions even after unemployment had been rising for more than a year. And the two supposedly revolutionary political figures in the current presidential race - Bernie Sanders and Rand Paul - each especially make some of the errors I have outlined here. So, you say you want a revolution?

It sure looks to me like there tends to be profit from trading momentum in short term interest rates. Will we ever be able to test this hypothesis? I'd love to. But I'm not sure I want to be short forward contracts if the Fed starts to raise rates and the yield curve flattens in our current environment. I'm not sure there is much room for rates to have positive momentum before they turn back down.

In the Financial Times (the source of the graph), Gavyn Davies discusses the graph thusly:

For about three decades, it has generally paid for traders to assume that the Fed will deliver a path for short rates that is lower than that built into the forward curve for interest rates at any given time. Maybe that partly reflects the fact that a risk premium is normally priced into forward interest rate curves. But, in addition, interest rates have been on a long run downtrend, with the Fed repeatedly choosing to deliver easier monetary policy than the market has expected. “Never underestimate the dovishness of the Fed” has usually been a profitable motto for traders.

This is shocking to me. Does he really think the Fed has been dovish for 30 years? What does he think inflation would have done if the Fed had been hawkish? Where does he think interest rates would be if the Fed had been hawkish?